Life and Health Insurance · Life Insurance · 5 min read
Dividends and Owner Elections
- Differentiate between participating and nonparticipating policies, identifying how divisible surplus generates policy dividends.
- Analyze the tax treatment of life insurance dividends and the rules governing policyowner dividend elections.
- Compare the operational mechanics, death benefit effects, and cash value impacts of common dividend options.
Nature and Sources of Policy Dividends
In life insurance, dividends are paid only on participating life insurance policies. Participating policies are most commonly issued by mutual insurance companies, where policyowners share in company performance. In contrast, nonparticipating policies are typically issued by stock insurance companies and do not pay dividends. A life insurance dividend generally represents a return of premium when the insurer's experience is more favorable than expected. It is critical to understand that a dividend is not an unearned premium refund.
Dividends are declared out of an insurance company's divisible surplus. Three primary factors contribute to this surplus: lower-than-expected mortality costs, higher-than-expected investment earnings, and lower-than-expected operating expenses. When death claims are lower, investment returns are stronger, or overhead costs run lower than projected, the insurer generates surplus funds that may be returned to participating policyowners.
Because future insurer performance cannot be guaranteed, future policy dividends are not guaranteed. For this reason, sales illustrations cannot present future policy dividends as guaranteed. If an insurer experiences an unfavorable year, dividends may decrease or not be declared at all.
Common mistakes
- Assuming that policy dividends are guaranteed because an insurer has a long history of paying them. Dividends are declared from surplus and cannot be guaranteed or illustrated as guaranteed.
- Confusing dividend options with settlement options. Dividend options dictate how surplus returns are handled while the policy is active, whereas settlement options govern how death proceeds or surrender values are distributed.
- Believing that all accumulated dividend values are entirely tax-free. While the dividend principal is generally tax-free up to policy basis, any interest credited under the accumulation at interest option is taxable as ordinary income in the year earned.
- Thinking evidence of insurability is required to buy paid-up additions or one-year term coverage with dividends. Both options allow the policyowner to purchase additional coverage based on attained age without any medical proof.
Key points
- Dividends are declared from divisible surplus on participating policies, typically issued by mutual insurers, and are never guaranteed.
- Surplus is generated by favorable insurer experience, including lower mortality costs, higher investment earnings, and lower operating expenses.
- Dividends are generally considered a tax-free return of premium up to the owner's investment in the policy, but credited interest on dividends is taxable as ordinary income.
- Owners can direct dividends to cash payments, premium reductions, accumulation at interest, paid-up additions, one-year term insurance, or an accelerated paid-up structure.
- Paid-up additions provide additional permanent life insurance with growing cash value and no evidence of insurability.
- The one-year term option buys temporary coverage for twelve months based on attained age, sometimes structured to match the policy's cash value as the fifth dividend option.
- Dividend choices can be modified for future declarations, but prior elections already applied cannot be undone.
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